• 094 03/03/2020

    Purchase Price, in the context of an acquisition, is not as simple as it might otherwise sound. To arrive at the Purchase Price for a target company the parties involved must first agree on the value of the company. This value is often defined in a stock purchase agreement as Base Purchase Price or Initial Purchase Price. 

    Using Base Purchase Price for purposes of this example, a series of adjustments must typically be made to arrive at the Purchase Price. This is largely because most transactions are contemplated on a cash-free, debt-free basis and assuming an appropriate level of net working capital at the closing, and it may be impossible to accurately measure net working capital on or prior to the closing date of the transaction. 
     
    Consequently, to arrive at the Purchase Price, the Base Purchase Price will need to be adjusted for the following:
    1. the amount of cash on the balance sheet;
    2. indebtedness;
    3. net working capital; and
    4. transaction expenses.
    Items (1) and (2) above adjust the Base Purchase price for a cash-free, debt-free transaction. This means that the Seller is entitled to the cash on the balance sheet on the closing date of the transaction, and that the Seller is responsible for debts owed by the company (defined as Indebtedness). Item (3) is addressed in a post titled "The Working Capital Adjustment in a Purchase Agreement." And item (4) is included to ensure that the Seller is responsible for the fees and expenses associated with the transaction that are incurred by the target company and/or the Seller.
     

    Purchase Price Adjustment in a Stock Purchase Agreement

    In summary, the Purchase Price will be calculated as follows:
    1. the Base Purchase Price;
    2. plus Cash;
    3. minus Indebtedness;
    4. plus the amount, if any, by which Net Working Capital is greater than the Net Working Capital Target;
    5. minus the amount, if any, by which Net Working Capital is less than the Net Working Capital Target;
    6. minus the Transaction Expenses.
    In a stock purchase agreement all of the capitalized words in the bullets above require definitions. The definition for Indebtedness frequently covers half a page or more (we have included an abbreviated definition). To visualize how the definitions and the calculation of Purchase Price come together we have included a summarized example on the pages that follow. 
     
    Stock Purchase Agreement Language:
    The download associated with this post contains hypothetical language detailing the above sequence as it might appear in a stock purchase agreement. Download PDF File.

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  • 093 02/19/2020

    The working capital adjustment in a stock purchase agreement can have a direct impact on the price paid for the business. Given that price is arguably the most important variable in a transaction, and that the working capital adjustment can impact price, it follows that the working capital adjustment deserves special attention. (PDF Document) 

    This adjustment is required because it is impossible to know what a company’s working capital (i.e., generally, current assets minus current liabilities) will be on a future date (specifically the date of the sale). It can take a business anywhere from a couple of weeks to a couple of months to close its books, making this an adjustment that can only take place after the transaction has closed.
     
    Sequence for the Working Capital Adjustment: 
    On the closing date of the transaction, Buyer will pay to Sellers an initial purchase price, which is subject to an adjustment for working capital (note: additional adjustments can be included, but this post will focus solely on the working capital adjustment). The initial purchase price will include an estimate for working capital for the closing date (Target Working Capital). 
     
    Between 60 and 120 days after the closing date, the Buyer will deliver a statement to Sellers with Buyer's calculation of working capital (Final Working Capital). If all parties agree that the calculation is accurate, then an adjustment will be made as follows.
    1. If the Final Working Capital is greater than the Target Working Capital (Excess Amount), then Buyer shall pay directly to Sellers an amount equal to the Excess Amount, and Buyer and Sellers shall promptly deliver a joint written instruction letter to the Escrow Agent to release all funds in the Working Capital Escrow Account to Sellers.
    2. If the Final Working Capital is less than the Target Working Capital (Shortfall Amount), then Buyer and Sellers shall deliver a joint written instruction letter to the Escrow Agent to release an amount equal to the Shortfall Amount from the Working Capital Escrow Account to Buyer.

    Purchase Price Adjustment in a Stock Purchase Agreement

    Example to Provide Context:
    When a healthy business is acquired, the purchase price is generally based on a multiple of earnings (commonly EBITDA). What the purchase price assumes, among other things, is that the business will have adequate working capital on the date it is acquired to maintain this level of earnings.
     
    For a simple example, let's eliminate all working capital accounts with the exception of inventory. Assume that you acquire a business that uses raw materials (a component of inventory) to sell a finished good. Post acquisition you learn that the business does not have any inventory. This is an extreme example that would hopefully never occur because you followed a proper due diligence plan, but it helps communicate the need to adequately measure working capital accounts. Without raw materials production would halt and you would have to use cash to purchase the amount of inventory required to continue operating. The working capital adjustment in a stock purchase agreement secures this cash from the sellers so that the buyer is made whole. 
     
    In other words, the working capital adjustment makes sure that the buyer receives a historically normalized level of working capital at closing so that the business can be operated as it was prior to the transaction.
     
    Stock Purchase Agreement Language:
    The linked document contains hypothetical language detailing the above sequence as it might appear in a stock purchase agreement.  

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  • 092 02/04/2020

    If an investment were to grow by precisely 6.7% each year for 200 years, and then lose half of its value in year 201, how would the investment record change?

    An article by Jim Grant, one of my favorite financial writers and analysts, highlighted this excellent thought exercise which provides an entertaining way to explore the difference between the two most commonly cited measures of investment performance: the internal rate of return (IRR) and the multiple on invested capital (MOIC). From the article:
     
    “Take that 200-year, 6.7% compound real return which [Jeremy Siegel, author of Stocks for the Long Run] first electrified the reading portion of Wall Street in 1994. …how would the record change if, in year 201 the market fell by 50%?”
     
    To provide some context, if a $100 investment achieved a 6.7% compound real return for 201 years the value of that investment at the conclusion of 201 years would be approximately $46 million. So what would the 201-year compound real return be if the value dropped to approximately $21 million in year 201 instead?
     

    IRR Portfolio Comparison

     
    The article continues:
     
    “You suspect that a 50% drawdown would play ducks and drakes with even a two-century performance record, and you confidently say so. But you are wrong: In fact, that seeming disaster would reduce it merely to 6.3%, a scant 40 basis points.”
     
    It is a surprisingly small discrepancy, and I wanted to use this as an opportunity to demonstrate the massive discrepancy in MOIC between the same two scenarios. The spreadsheet visible below can be downloaded here.
     

    IRR vs MOIC

     
    Comparing these two scenarios against one another, you will notice that the MOIC is less than half in the second scenario, but the IRR for the cash flows suggests little has changed. It goes to show that an investment’s time horizon is the reason that both of these metrics should always be considered when evaluating performance. 
     
    To take the point a step further, imagine if in year 201 the investment lost 99% of its value. How drastic would you expect the difference to be in the event that an investment’s value is all but wiped out? A 99% loss in year 201 after growing at 6.7% for the prior 200 years would result in an internal rate of return of 4.25% for the entire investment period. In stark contrast, the value of the investment would be $429,422 versus $45,819,285 had it just continued to grow at 6.7% in year 201 (download the template if you would like to make this change yourself).
     

    IRR vs MOIC Portfolio Wipe Out

     
    Jim Grant wrote the article to demonstrate that “stocks, as measured over generations, appear invincible.” But I thought it also provided an excellent opportunity to demonstrate why IRR and MOIC should be used in tandem to measure investment performance. While it is clearly an extreme example, I find that extremes can occasionally help communicate valuable lessons.  
     
     
 




 



Models are:
 
A) really boring
B) pretty sweet
C) super important
D) somewhat easy
E) kind of hard
F) fun
G) all of the above

 

 


*Answers a, b, c, d, e, f and g are all correct.